Marathon Oil pulls out of pioneer Sakhalin II project

Marathon Oil Co. is pulling out of the $10 billion Sakhalin II oil and gas project off Eastern Siberia that it helped pioneer into the first production-sharing agreement with the Russian government and the first offshore production under such a deal. But after that decade-long effort, Marathon is now looking to maximize its near- to mid-term cash flow and improve its financial flexibility.


Sam Fletcher
OGJ Online

Marathon Oil Co. is pulling out of the $10 billion Sakhalin II oil and gas project off Eastern Siberia that it helped pioneer into the first production-sharing agreement with the Russian government and the first offshore production under such a deal.

But after that decade-long effort, Marathon is now looking to maximize its near- to mid-term cash flow and improve its financial flexibility. So it has signed a non-binding letter of intent to swap its 37.5% operating interest in the Sakhalin Energy Investment Co. Ltd. consortium to Shell Sakhalin Holdings BV, which already holds a 25% interest.

In return, Marathon will acquire all of Shell UK Ltd.'s 28% interests in the Foinaven field and associated infrastructure, located in the Atlantic Margin west of the Shetland Islands and operated by BP Amoco PLC. Marathon also will get a 3.5% overriding royalty on 100% of production in eight blocks developed by Shell in the Gulf of Mexico, including the prolific Ursa field, which set a production record of 50,150 boe/d shortly after it came on stream in April 1999.

Those are "two significant producing properties, each with growth potential, located in core areas for Marathon," said David Golder, the company's vice president of international production. However, no estimate of the value of those properties was given, and Marathon officials declined to say how much they have invested in Sakhalin.

Under the pending agreement, Marathon would be reimbursed for its Sakhalin expenditures this year�some $50 million, according to Shell sources. A definitive agreement is expected to be signed in September, with the actual exchange of operations scheduled in the fourth quarter, officials said Thursday.

Shell's tack
"We are pleased now to take the lead in the next phase, which is to bring Sakhalin's gas reserves to development," said Rein Tamboezer, president of Shell Exploration & Production Services (RF) BV. "We feel that Shell, with its extensive experience in the LNG business in the Far East, can add considerable value to the venture."

That's why Shell proposed the trade to Marathon, who had guided the consortium through the first phase of developing offshore oil operations. Shell hopes to begin selling LNG by 2007 to Japan, South Korea, and other Asian countries. Its position close to South Korea and Japan makes Sakhalin particularly attractive.

However, a 1997 study prepared by international oil economist Pedro Van Meurs for the State of Alaska ranked the Sakhalin II project well below other low-cost gas projects in Brunei, Indonesia, Malaysia, and Viet Nam that he said could supply gas to Asian markets more economically. Moreover, Russian officials could focus on Sakhalin's gas as a means to solve the energy problems of eastern Russia. Local Sakhalin officials have been agitating all along for gas to provide cheap electricity and heating.

The deal is contingent upon an arrangement with other members of the consortium for Shell to provide both upstream and LNG services to Sakhalin Energy. Those other members�Mitsui & Co. Ltd. with a 25% interest and Mitsubishi Corp with 12.5%�have agreed in principle, so long as their rights are safeguarded.

Sakhalin II
The Sakhalin II project encompasses the Piltun-Astokh oil field, located in 30 m of water on the northeast shelf 15 km off Sakhalin Island; and the Lunskoye gas field, in 50 m 20 km offshore. That area is thought to contain reserves of 1 billion bbl of oil and 14 tcf of natural gas.

Oil production from the Piltun-Astokh field began last July, followed by the first export in September via its floating storage and offloading (FSO) vessel. Production totaled 1 million bbl in 1999 and is expected to jump to 13 million bbl this year. But oil production is possible only 6 months each year because area waters are choked by ice the rest of the time.

The consortium currently is evaluating alternatives to supply associated gas for Russian utilization. Officials also are working to obtain sales contracts for Lunskoye gas, which they hope to be producing by mid-decade. To prevent disruptions of gas production, Shell officials plan to lay a pipeline to a yet-to-be-built LNG plant at an ice-free port on the southern tip of the island.

Offshore exploration in the Sakhalin area dates back to the mid-1970s, when Japan set aside its territorial dispute with the Soviet Union in an effort to diversify its energy supplies following the 1974 energy crisis. In 1989-90, the former Soviet Energy Ministry, in conjunction with McDermott International Inc., examined the feasibility of a joint venture to develop the Lunskoye and Piltun-Astokh fields. In May 1991, the Soviets had a tender competition for development of those fields.

That drew bids from six companies or consortia, including a joint offer from Exxon Corp. and Sakhalin Oil Development Cooperation Co. Ltd. (SODECO), a group of 18 Japanese companies formed in 1975 by the Japanese government and Japan National Oil Co. SODECO already held the rights to the Odoptu and Chayvo fields off Sakhalin Island. The decision on that tender was delayed by intervention of Sakhalin authorities who insisted on new requirements for foreign investors.

In January 1992, the Russian government finally accepted the bid by the McDermott-Marathon-Mitsui (MMM) consortium. That triggered legal action by Sakhalin officials who favored Exxon-SODECO. As a result, the winning bid was downgraded to the right to complete a feasibility study, with development rights to be decided later.

Meanwhile, Shell and Mitshubishi joined the consortium, which then became MMMMS. After submitting its feasibility study, the consortium created Sakhalin Energy in 1993 to manage the development, production, financing and marketing aspects of the project.

In June 1963, Sakhalin Energy signed the first Russian production-sharing agreement even before the law on production sharing was passed by the Duma and necessary legislation like the tax law was in place. At the time, it represented the largest single US investment in Russia.

With reactivation of the SODECO project, the Sakhalin Energy project became known as Sakhalin II, although its production-sharing agreement was the first in place. Development of the project began in June 1996.

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